The security group is struggling to bring its debt pile under control with a
challenging year ahead, says Questor

G4S [LON:GFS]the security services provider is proving just how difficult it is to turn around the fortunes of a company that has embarked on a multi-year global expansion plan fuelled by debt.

The shares slumped to a six-year low yesterday after broker Jefferies raised concerns about emerging market growth and the health of the balance sheet.

False sense of security

The business is built on a fairly simple model. The company provides security staff for a range of sites such as sports events, corporate and public sector buildings, and industrial facilities. The near 620,000 strong army of staff is paid fairly low wages, at or around the minimum wage.

The beauty of these contracts is that they tend to be long-term, and generate regular cash payments. What’s more, the cash that comes from government customers are effectively backed by a sovereign credit rating.

Debt fuelled expansion

The problem at G4S is that the company decided to use steady cash generation to expand far too quickly by using ever-increasing amounts of debt.

While the expansion continued apace, control over service quality struggled to keep up. This came into sharp focus during the London Olympics, when G4S overpromised and under-delivered in front of the world’s media.

The management team also became focused on chasing revenue growth.This blinded them to the possibility that not every contract would deliver long-term profitability. A painful process now has to take place in order to discover the contracts which the company should focus on.

Costly legacy

G4S is now attempting to deal with the legacy of that expansion. The most recently reported net debt (the total amount of debts less cash) was £1.68bn at the end of June, while net assets were £765m. With few assets to underpin the share price the equity value becomes increasingly sensitive to movements in the earnings. At the same time, the emerging markets into which it expanded are suffering from a sharp drop in the value of their currencies. This means revenues and profit from these divisions are worth less when translated back into sterling for reporting purposes.

Emerging markets such as Brazil, India and South Africa contribute about a third of total revenue. Revenue growth from these countries in the first-half was 5.7pc, but this was not adjusted for currency devaluation. The Brazilian real and South African rand have dropped by 25pc against the pound since the start of 2015, while the Indian rupee is flat.

G4S has to undertake a major balance sheet restructuring to bring its debts under control, but the company’s dilemma is that it can’t sell too many parts of the business as it would then lose the earnings and cashflow needed to support interest payments.

Challenging year ahead

G4S does have some factors in its favour. Revenue outlook is helped by a £5bn contract pipeline and expected organic revenue growth of between 5pc and 8pc a year. The company could also raise cash by exiting some of the youth offender contracts in the UK that have brought the most recent wave of problems.

However, Questor believes the dividend will remain at risk until debt levels are meaningfully reduced.

The possibility of another equity issuance cannot be excluded. The shares, which are trading on 14 times forecast earnings and offering a prospective dividend yield of 4.4pc, don’t adequately price in the risk.